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Capital gains distributions are commonly paid by mutual funds and you may receive a capital gain payment from other investment types such as a real estate investment trust (REIT). How the capital gain affects your cost basis depends on what you do with the distribution. Your cost basis determines the amount of tax you will pay when you sell the investment.
Capital Gains Distributions
A mutual fund capital gains distribution is the result of the fund earning profits on the securities it has held and sold. Funds are required to distribute net profits to shareholders at least once a year. Must funds payout the distributions near the end of the year. It is possible to receive two capital gains payouts - one for long-term capital gains, and one for short-term gains. The capital gains distributions must be reported on your income tax return for the year.
Taking Cash Distribution
If you receive capital gains payments as cash, the distributions will not change your basis in the investment. The distribution will cause the share price to decline by the distribution amount, decreasing your gain or increasing your loss based on your investment basis. For example, assume you purchased 100 shares of a fund at $10 per share, making your basis in the investment $1,000. The share price rises to $12 and the fund pays a $1 per share capital gain. You will receive $100 as the distribution and the share price will drop to $11 on the date of the distribution. Your basis will remain at $10 per share or $1,000.
Mutual fund investors can reinvest capital gains distributions back into more shares of the fund. Reinvested capital gains increase your cost basis in the investment. Using the fund example from the previous step, if the $100 capital gain is reinvested, the money will buy an additional 0.09 shares at $100 per share. After the reinvestment, the investor will own 109.09 shares with a cost basis of the original $1,000 plus the $100 reinvested for a total basis of $1,100.
Tracking Your Basis
If a mutual fund investment is owned for a period of years, the amount of reinvested capital gains may significantly increase the cost basis of the investment. A higher basis reduces the capital gains taxes to be paid if the investment is sold. It is important to keep a record of capital gains distributions that have been reinvested. Mutual funds send out year-end statements that list all fund transactions for the year. Maintain this statement in your long-term records concerning the investment.
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